Deflation Still Unlikely, but Mind the Risks
February 26, 2009
By Richard Berner | New York
Judging by the rebound in inflation breakevens, deflation risks have subsided. Five- and ten-year breakeven inflation rates have bounced sharply, the former from negative into positive territory; they now stand at 60bp and 110bp, respectively. Small wonder, given aggressive easing of monetary policy, the recent bump in commodity prices, the run-up in gold quotes, January US inflation data, and the recent rise in longer-term consumer inflation expectations.
Thanks to aggressive monetary easing and coming corporate actions to cut capacity, we don’t think that deflation is the most likely outcome. But investors should not entirely dismiss deflation risks, as tumbling operating rates are eroding pricing power. We think that uncertainty in the inflation outlook is now a key driver of those expectations and of breakevens. From a tactical perspective, therefore, our interest rate strategists, Jim Caron and George Goncalves, believe that inflation insurance in the form of breakevens should be sold for now. There is no mistaking the upturn in some inflation determinants. Partly to combat the risk of deflation, the Fed has gone to a zero interest rate policy and is conducting ‘credit’ and quantitative easing. The CRB raw industrials index has moved up about 5% in the past 45 days following a 35% plunge over the last eight months of 2008. Spot gold prices have jumped US$300 to nearly US$1,000 since November. Empirical work at the Bank of Canada suggests that gold prices are a good leading indicator for inflation for several countries (see Greg Tkacz, “Gold Prices and Inflation”, Working Paper 2007-35, June 2007). And longer-term consumer inflation expectations are climbing again; measured by the University of Michigan’s canvass, 5-10-year inflation expectations have bounced 40bp to 3% in the past two months. Moreover, recent inflation readings seem to belie a move to deflation. On the one hand, the plunge in energy quotes has pulled year-on-year headline inflation into negative territory, with a decline in the CPI of 0.2% in January from a year ago; last July, soaring energy quotes pushed headline inflation to 5.5%. But core inflation is still strongly positive and has declined more slowly, reflecting the lags between the time that slack in the economy increases and inflation falls. Measured by the change in CPI from a year ago, inflation excluding food and energy declined from 2.5% last July to 1.7% in January. However, higher-frequency readings and a closer look at other inflation indicators suggest a somewhat higher risk of deflation: On a six-month annualized basis, CPI core inflation has declined to 1%, nearly matching the lows last seen in spring 2003 and the record-lows (in the modern history of the data, which start in 1957) of the early 1960s. In addition, ‘pipeline’ price pressures are ebbing fast, with core intermediate goods prices falling at a record 13.2% annual rate in the past six months. This sub-index is often a good leading indicator of finished wholesale goods inflation. While that plunge so far merely reverses much of its leap in 2008, growing economic slack suggests that it will decline further. Moreover, import prices are also decelerating, reversing the impetus to higher inflation from accelerating import quotes in 2008. While ‘pass-through’ from exchange rate changes has declined over the past two decades, the dollar’s appreciation over the past year should reverse some of the previous run-up in consumer and capital goods import prices, and those reductions are just starting to show up at ports and at the retail level. That’s more likely now as a severe global recession creates more slack in the US and global economies. Prices for consumer goods excluding autos accelerated to a 3% clip last summer; six months later, a rebounding dollar and weak demand have cut the pace to 1.5%, and outright declines seem likely. In addition, the deceleration isn’t confined to goods-producing industries; prices for industry output at the wholesale level are decelerating in a variety of service industries. A composite that includes prices for financial services, leasing, consulting, recreation and repair businesses decelerated to -0.9% in January from 1% at the beginning of 2008. Further, the housing bust has created a glut of owner and rental properties, which will depress rents. Owners’ equivalent rent (one-third of core CPI) has decelerated to 2.2%, less than three-fifths of the level a year ago, and this deceleration likely will continue. Finally, slack is increasing in the industrial and service economies: Measured by either industrial operating rates or harder-to-measure ‘output gaps’, the level of slack is moving to record lows. Both the change and the level matter. Other things equal, prices tend to accelerate when utilization rates are rising and decelerate when they fall. While there’s no threshold level of capacity utilization above which prices rise and below which they fall, rock-bottom operating rates tend to be associated with falling prices. Manufacturing operating rates have plummeted by more than 12 percentage points in the past 18 months to a record-low 68%. Likewise, the ‘output gap’ – the difference between actual and potential GDP – likely fell to between -5% and -6% in the first quarter, and further declines are coming in both. We estimate that, if our forecasts for factory output and GDP are on the mark, manufacturing operating rates could fall by another four points, and the output gap could widen to 7-8%. Cross-currents abound in the inflation outlook, creating uncertainty – and opportunity: Ongoing weakness in economic activity threatens to open significantly more slack in the US and other economies, which will push inflation lower over the next several months. In contrast, aggressive policies could eventually – over the next few years – push it higher, and the sharp rebound in spot and distant-forward inflation breakevens reflects these concerns. Thus, inflation uncertainty has increased, at least in the near term, suggested by the increased variability in surveys of inflation expectations. This stepped-up variability hints that surveyed consumer expectations may overstate inflation concerns. However, as Jim Caron and George Goncalves point out, market-based measures of inflation volatility have not shown a parallel increase, and thus have not richened to levels that would warrant selling it. Put differently, inflation swaptions never really cheapened significantly, so selling inflation volatility is difficult. Instead, Jim and George note that inflation insurance three months ago was cheap in the cash markets, with implied 5-year breakevens (BEIs) going below zero as investors sold TIPS. However, given the recent rise in TIPS inflation expectations, breakeven trades are no longer cheap. As a result, they suggest that investors who expect a move towards lower inflation should sell breakevens because in the near term CPI-based carry prospects will be less in the months ahead.
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F2009/10 Budget – Not as Generous When Needed
February 26, 2009
By Denise Yam, CFA | Hong Kong
Summary and Conclusion Financial Secretary John Tsang presented the F2009/10 budget speech on February 25, 2009, his second since he assumed the post in July 2007. Amid the financial tsunami and the rapidly evolving global recession, there was considerable expectation and social pressure for economic support measures, especially when governments around the world, with far less fiscal resources than Hong Kong, have already unveiled aggressive stimulus plans since the onset of the financial tsunami last September. Nevertheless, the latest budget is not as stimulative as could be expected, given the adverse economic conditions currently, and even not as generous as last year’s budget when the economy was growing robustly. While those with high expectations for immediate stimulus or relief measures are likely to be disappointed by the latest budget, the government demonstrated that it has not lost sight of Hong Kong’s long-term strategic development amid the ongoing global financial turmoil. Comprehensive plans were unveiled with regard to the continued development of the key industries and strengthening economic linkages within the Greater China region. All in all, as the budget offered a limited boost to the economy, we maintain our forecast for a 3.8% real GDP contraction in 2009, while tweaking our CPI inflation forecast to 1.5% (from 2%) to take into account the latest fiscal measures and weak domestic demand outlook. Better-than-Expected F2008/09 Outturn The government’s updated estimates point to a better-than-expected fiscal outturn in F2008/09 (year ending March 2009). There is a small estimated deficit of HK$4.9 billion, or 0.3% of GDP, against the original budget of a HK$7.5 billion deficit, plus the HK$11 billion package (spread over two years) announced in July 2008 and HK$10 billion donation to the Sichuan earthquake relief. This is a significant upside surprise, given the sharp turnaround in economic conditions. Although asset market weakness slashed stamp duty revenues by 36% from the HK$52 billion in F2007/08, the government received better-than-expected revenues from profits tax (record HK$103.2 billion, against HK$83.3 billion in the original budget) and salaries tax (HK$36 billion, against HK$26.4 billion in the original budget), while the return on fiscal reserves invested with the Exchange Fund (EF) remained elevated at HK$37.6 billion – despite the losses made at the EF – as it was calculated based on average returns over the past six years. As a result, Hong Kong enjoyed a surplus in its operating fiscal account for the fourth straight year, of an estimated HK$18 billion (versus HK$6.3 billion budgeted deficit originally), though down from HK$71.6 billion in F2007/08. The operating deficit before investment income amounted to HK$19.6 billion (HK$49.7 billion surplus in F2007/08), smaller than the budgeted HK$43.4 billion. A Deficit Budget for F2009/10 – but Not Quite Stimulative Amid unfavorable macro conditions, the government projects a 15% decline in revenues in F2009/10. Budgeted government expenditures are also to slip, by 3.6%, despite the increased need for economic support, though the Financial Secretary defended this year-on-year comparison and attributed it to the significant one-off giveaways in F2008/09. All in all, the government expects to run a deficit budget of HK$39.9 billion in F2009/10, or 2.4% of GDP. Stripping out investment income on reserves, the fiscal injection into the economy will only be 1.5% of GDP, plunging from last year’s 8.7%. What Are the F2009/10 Giveaways? The giveaways in the coming fiscal year fall far short of expectations, and also short of those granted last February. The concessions amount to a much smaller HK$8.4 billion (0.5% of GDP) compared to last year’s HK$52 billion (3.2% of GDP). A 50% rebate was only granted to personal income taxes (salaries tax and personal assessment), with a cap of HK$6,000 (costs HK$4.1 billion), compared to the 75% rebate last year, with a cap of HK$25,000, offered on personal, property as well as corporate profits taxes. The concession on property rates, which had been a key giveaway since 2007, had been greatly reduced. From up to HK$5,000 per property per quarter in place since 2Q07 through to 1Q09 (except 4Q07), only a waiver of up to HK$1,500 is offered this time round, and only for 2Q09 and 3Q09 (costs HK$4.2 billion). The bonus social security (CSSA, elderly, disability) allowances and subsidies on electricity bills will no longer be offered this year. Government fees and charges will nevertheless be frozen for another year. Meanwhile, the government is offering some assistance to renters of government premises through a 20% discount on rentals for a period of three months (costs HK$83 million). Expenditures Center on Job Creation Recognizing the significant downside risks to consumer confidence and social harmony upon further deterioration in labor market conditions, instead of large giveaways, the latest budget dedicated considerable attention and financial resources to job creation or preservation. Specifically, the government will facilitate the entry of this year’s university graduates into the labor market through the ‘Internship Program for University Graduates’, where HK$140 million will be given as subsidies to employers. Various government projects and infrastructure investments will also play a role in providing job opportunities. The government has earmarked a total of HK$1.6 billion to create 62,000 jobs and internship opportunities over the next three years. Focused on Longer-Term Development… The government defended its cautious stance on concessions with the desire to put expenditures to constructive use that accrue to Hong Kong’s longer-term development. This is understandable, and demonstrates that the government has not lost sight of Hong Kong’s long-term strategic development amid the ongoing financial turmoil. Comprehensive provisions have been planned towards Hong Kong’s strategic economic positioning, including the development of the four pillar industries (financial services, logistics, tourism and business/professional services), upgrading infrastructure and strengthening economic linkages within the Greater China region. …but Limited ‘Special’ Measures for the ‘Special’ Situation Nevertheless, we believe that the latest budget likely disappointed those expecting more immediate relief from the ongoing recession. Amid the deepest global recession in decades and the inevitable economic contraction this year, we saw it as an opportune time to tap into Hong Kong’s ample fiscal resources to help the economy ride through the tough times. Although the generous giveaways at last year’s budget – ironically when the economy was growing robustly – unfortunately ran down some of the government’s ammunition for policy stimulus, Hong Kong certainly still has the most ample fiscal resources relative to other economies in the world for a stimulative budget. Fiscal reserves (net of government debts and debts guaranteed) stood at a record high of HK$503 billion at end-2008, equivalent to 30% of GDP, compared to mountains of debt in other economies in the world. (At the lowest point in the last cycle, fiscal reserves dropped to HK$232 billion, or 19% of GDP, in October 2003.) We think there is a lot that the government can do before hurting 1) its finances, and 2) confidence in the HKD. However, the latest budget appears to be little different from the usual budgets, where the government reactively fine-tunes revenues and expenditures and remains fixated on minimizing the deviation from balancing the books, instead of proactively rolling out radical economic stimulus measures in the face of an unprecedented global turmoil. The concessions and rebates had all been granted in the past when the government enjoyed budget surpluses, even during economic upturns. Moreover, as the HK$4.1 billion tax rebates will only come in the form of a credit to next year’s tax bill (due in early 2010), the immediate impact on consumer sentiment this year is very limited. Nevertheless, this also preserves ammunition for more relief measures (which could be announced at the October 2009 Policy Address) should economic conditions turn much worse. More Deficits in the Next Few Years The government’s latest medium-range forecasts appear far less optimistic than before. Deficits are expected to sustain through to F2013/14, but the downward revisions from the forecasted surpluses from last year’s projects mainly stem from much less ambitious forecasts for investment income and capital revenues (land sales), rather than increased government spending, suggesting that the government has not included much of an increase in expenditure plans for the next few years. In any case, the latest budget speech was silent on any measures that may be introduced to reduce the wild cyclical fluctuations in government revenues through broadening Hong Kong’s tax base, which indicates the government’s continued complacency with its fiscal management principles. Maintaining Growth While Lowering CPI Forecasts The Hong Kong economy grew by 2.5% in real terms in 2008, slightly below our forecast (2.8%). The economy dipped into negative year-on-year growth in 4Q08, contracting by 2.5%, more severe than our forecast of 1.5%, with weakness seen in all segments: 1) private consumption fell 3.2%Y, 2) private investment dropped 20.1%, 3) goods exports fell 1.7%, though cushioned by the 3.5% drop in imports, and 4) service exports grew only 0.7%, the weakest gain since SARS-hit 2Q03. (For more detailed analysis on the 4Q08 GDP statistics, please refer to our report, Deeper into the Recession, February 25, 2009.) With limited stimulus from the budget, we are maintaining our forecast for 3.8% real GDP contraction in 2009 (consensus: -2.1%, government: -2% to -3%), factoring in an unprecedented 11% shrinkage in merchandise trade flows and 8% dip in service exports, unseen since 1998. On the inflation front, we are taking our 2009 CPI forecast down to 1.5% (consensus: 1.3%, government: 1.6%), from 2% previously, to take into account the latest fiscal measures (two quarters of rates concessions) and weak domestic demand outlook (we last downgraded our GDP growth forecast in mid-January without changing our CPI forecasts in anticipation of the budgetary measures). Underlying inflation is set to dip continuously from the latest 4.5% in January to negative territory by 3Q09. The headline CPI, on the other hand, could flirt with deflation in mid-year because of the downward bias from fiscal concessions, but would rebound briefly in 2H09 due to the expiry of current concessions, before dipping into outright deflation at year-end, in our view. Looking to 2010, even assuming that fiscal concessions will be gradually phased out, the consumer price level will remain depressed in the aftermath of the property market downturn as home renters realize lower residential rentals at new contracts, while retail and service outlets pass on lower premises rentals to customers. We maintain our 1.5% deflation forecast for 2010 (consensus forecast: +1.5% inflation).
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Meeting Doubters Head-On
February 26, 2009
By Mohamed Jaber | London
The government of the emirate of Dubai announced on February 22 the launching of a US$20 billion bond program. The Central Bank of the UAE has fully subscribed to the first tranche of the 5-year, US$10 billion unsecured bond, which was issued at a fixed rate of 4%. The official announcement stated that “this program will secure the necessary funding for Dubai to meet its financial obligations and continue its development program”. However, no information was given regarding the timing and terms of subscription pertaining to the second US$10 billion tranche. This is a very positive development as the funds will greatly ease the current refinancing constraints facing Dubai’s public and quasi-public entities. Over the past six months, the pressure on these institutions rose significantly as concerns about their relatively high level of indebtedness increased. Given Dubai’s scarce oil resources, it had relied on relatively inexpensive external credit to finance massive real estate projects and facilitate the growth of a diversified economic base. In the process, however, it has also managed to accumulate a significant amount of foreign debt. Fitch Ratings recently estimated Dubai’s total non-bank external debt to be around US$69 billion, or about 85.4% of Dubai’s 2008 GDP; this is consistent with other official and market estimates of the emirate’s sovereign debt. Although relatively high, the size of this debt would have been manageable under normal circumstances. However, following the dramatic turn that international credit markets have taken since mid-2008, the cost of servicing and refinancing Dubai’s debt has risen significantly. Based on market estimates, US$12-16 billion of this debt is due to be refinanced by the end of 2009. As such, this week’s announcement will go a long way towards easing market concerns about the future solvency of the emirate’s large quasi-public institutions. The cost of debt to Dubai’s entities is expected to drop significantly following this issuance. Market concerns about the availability of external financing, coupled with uncertainty about potential federal support, had driven up the cost of Dubai’s debt and inflated the cost of insuring against defaults. CDS spreads on Dubai’s 5-year sovereign bonds had gone up from about 150bp in October to around 900bp by the end of last week. However, investors’ reaction to Sunday’s announcement has been very positive. The yield on the December 2009 bond of Nakheel, a large government-owned developer, dropped from about 85% on February 20 to around 40% on February 23. Moreover, Dubai’s sovereign CDS spread narrowed by about 150-200bp on the day. Although we project further tightening of these spreads over the coming days, we do not see them returning to their October levels anytime soon, mainly due to: • The continued global risk-aversion to emerging market credit, as reflected by the relatively wide spreads on other sovereign debt in the region. • The potential need for additional fiscal and monetary measures to strengthen market confidence, address the remaining downside macro risks and catalyze economic growth. • The likelihood of having to offer the second tranche of the bond program at more attractive terms in order to generate sufficient interest from investors. However, it is not clear at this point whether the second tranche will indeed be tapped or whether it would be open to public participation should that happen. Consumer and investor confidence is expected to increase, but its impact on domestic demand may be limited. The US$10 billion bond issuance – along with the remaining proceeds from a US$6 billion syndicated loan launched by the Investment Corporation of Dubai (a large Dubai government holding company) back in September – should provide the Dubai government with sufficient funds to meet most of its refinancing commitments for the rest of the year. In turn, this could potentially: (i) increase market confidence in the solvency of the emirate’s quasi-public entities; (ii) ease their access to additional external financing; (iii) re-energize domestic capital expenditures; and (iv) help increase consumer confidence. However, the overall economic impact of this large issuance – equal to almost 97% of the Dubai government’s budgeted spending for 2009 – may also be dampened by: • The fact that most of the bond receipts are expected to be used for the refinancing of outstanding debt. As such, they are not likely to have a significant impact on domestic spending, given that beneficiary institutions will not be able to use these funds to finance new investment projects. • The external leakage effect resulting from the likely use of a significant portion of these funds to refinance debt obligations to foreign investors. The domestic multiplier effect of these government outlays will thus be substantially weakened. The monetary impact of the central bank’s subscription to the bond issuance will depend on where the Dubai government decides to hold the funds. Given that the bond issuance is in US dollars, we do not expect any initial impact on the overall size of the central bank’s balance sheet. Technically, the transaction should lead to a reduction in the size of the central bank’s foreign assets and to an equal increase in the size of its dollar-denominated domestic holdings. (The classification of an asset/liability as domestic or foreign depends on the residency of the counterparty, not on the currency of denomination. As such, the US dollar-denominated bond issued by the government of Dubai would still be classified as a domestic asset on the central bank’s balance sheet.) Therefore, if the Dubai government were to decide to place its bond issuance receipts abroad, the transaction would have no significant impact on the UAE financial sector. However, if the Dubai authorities were to deposit these funds in domestic financial institutions, then the net economic effect might be non-trivial. Based on recently released January 2009 statistics, this would be equivalent to increasing total deposits in the banking system by about 4%. As such, this could hypothetically provide UAE banks with additional liquidity and allow them to reduce their loan to deposit ratios from the current 113% to around 108%. The effect on individual banks may be even more significant if these deposits were to be placed exclusively within Dubai-based financial institutions. Interestingly, the new dollar-to-dirham swap facility that the central bank introduced last December could potentially serve the banks well in this respect. However, we believe that the potential costs of depositing these funds in domestic banks may preclude the government from doing so. Given the debt refinancing needs of Dubai’s public entities, it is highly probable that the government will need to withdraw the majority of these funds over the next 12 months. This may indeed prove to be systemically risky if these funds were deposited within domestic financial institutions. Based on this, we believe that the funds will most likely be held outside domestic banks, with little net impact on domestic liquidity. The debt issuance reduces the systemic risk attached to Dubai’s large quasi-public institutions and provides them with much-needed breathing room, but more transparency is still needed. We have consistently argued in the past that Dubai’s systemically important quasi-public entities, such as Nakheel and DP World, would not be allowed to fail (see United Arab Emirates: Revising Our Near-Term Outlook, November 21, 2008). We had also proposed that in order to reduce market speculation and ease investor anxiety about these companies, greater transparency was needed with regard to: (i) the amount of financing that these firms required over the medium term; and (ii) the availability of alternative funding sources should the cost of non-governmental financing remain prohibitive. To this end, Sunday’s bond issuance will go a long way towards reducing the ambiguity surrounding the latter constraint and underlining the federal government’s readiness to provide support to Dubai-based institutions, should they need it. It may be worth noting that had such a program been established earlier on, it may have helped to reduce the burden of higher risk premia and credit constraints that some of Dubai’s public and private institutions have had to endure since 4Q08. Moreover, the continued lack of transparency surrounding the financial soundness of Dubai’s publicly controlled institutions may keep fuelling market speculation about the extent of their debt liabilities. In turn, this could dampen the positive impact of the bond issuance. In light of this, we believe that a higher level of disclosure would further help to boost investor and market confidence and catalyze economic growth. The announcement provides an unequivocal show of support for the Dubai government and its institutions. Although the bond issuance was subscribed to by a federal authority, the central bank, it also provided a strong show of support by the emirate of Abu Dhabi. It may be important to note here that Abu Dhabi funds about 50% of the federal budget and provides for US$8-10 billion in federal services annually. The emirate also accounts for about 95% of the UAE’s oil production and controls most of the country’s massive stock of official foreign assets. As such, Abu Dhabi’s implicit backing of this deal should help to ease market speculation about whether the emirate would support the government of Dubai if it were to run into funding constraints. Given the strong and symbiotic relationship between these two emirates, we have consistently maintained that Abu Dhabi would indeed provide the necessary support to its northern neighbor. Moreover, we have argued that the benefits to Abu Dhabi from maintaining a strong federation far outweigh the costs of providing Dubai with temporary financing by using a fraction of its massive reserves. The central bank’s actions have reinforced our conviction in this regard. However, a clear and unambiguous official stand on this issue by the federal or Abu Dhabi governments may still be required if market speculation does not significantly subside. In sum, there is a need for a greater degree of transparency on the part of both public and private entities during these times of heightened speculation and investor anxiety. Moreover, a clear and concerted effort by all levels of government in the UAE is necessary in order to tackle the challenges facing the federation and to avoid any further fallout from the global financial turmoil.
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